MagicDiligence (< 20)

March 2009

15

Spend a little time reading about investing and valuing businesses, and it's inevitable that you will encounter the "golden rule" of business valuation: a business is worth the value of all future free cash flows, discounted to present value. This, of course, sounds simple, but actually involves much guesswork when it comes to determining things like expected growth in cash flows, as well as how much to discount them by. Even something as simple as determining what current free cash flow is can cause arguments amongst experienced investors! In this article, we will take a look at a few formulas used to determine current free cash flow and give a take on what the best is. But first, let's review why it is such an important concept.

By definition, free cash flow is the amount of cash generated by a business that is not needed to maintain operations. Since the purpose of any business is to generate cash for it's owners (otherwise, why be in business?), you can see why free cash flow is really the most important statistic in investing. Note that we are talking about cash here, not reported earnings or net profit. The difference can be significant, as reported earnings often involve assumptions involving the value of intangible assets and certain expense items such as stock options. Cold hard cash, on the other hand, is as tangible as it gets and cannot be fudged by accountants. For more information, have a look at previous articles on understanding the income statement and understanding the cash flow statement. Free cash flow is the amount left over that can be used to provide value to shareholders in several ways: by paying a dividend, buying back shares, or re-investing in the business to grow revenues and profits. [more]

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Omnicom Group (OMC) is the largest advertising and marketing services company in the world by revenues. The firm is structured as a holding company, consisting of three global marketing networks: BBDO, DDB, and TBWA . Each of these networks consist of numerous individual agencies. The lines of business are loosely grouped into four segments. Traditional media advertising comprised 43% of fiscal 2007 revenues - these are your television, print, and radio ads. Other groups include customer relationship management (36%), specialty/niche advertising (10%), and public relations services (10%). Omnicom also has a wide geographic reach and diverse customer base, operating in over 100 countries and servicing over 5,000 clients. Almost half of revenues are generated outside the United States, mainly in Europe.

It's instructive to give an example of how a large integrated marketing firm provides value to a customer. Take one of Omnicom's campaigns, the highly successful "I'm Lovin' It" campaign developed and implemented for McDonald's (MCD). Omnicom's services here cover a wide variety of topics. First, McDonald's would have consulted with the company in the theme and brand positioning development to come up with the ideas in the first place. Then, Omnicom's agencies would then develop a pilot campaign and test it against focus groups. Once it was determined to be successful, the full rollout of "I'm Lovin' It" can begin, with Omnicom developing television, print, Internet, radio, and various other ad materials, and making the strategic buys for placing them. Omnicom would have also identified attractive sponsorship events for McDonald's, such as the 2008 Olympics. The firm's services are so broad that they could conceivably also assisted in designing window and panel marketing inside the McDonald's locations themselves, as well as container designs for the food items! As you can see, such an integrated set of services adds a lot of value, especially for big firms rolling out large marketing campaigns. Some of Omnicom's large clients include FedEx (FDX), Clorox (CLX), even marketing giant Proctor & Gamble (PG). [more]

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In Joel Greenblatt's The Little Book that Beats the Market, the Magic Formula strategy returned over 30% a year. Is this result obtainable going forward or did the study's time period skew results unrealistically? [more]

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Polo Ralph Lauren (RL) is a well known designer and marketer of branded apparel and accessories. Some of it's well known brands include Polo, Ralph Lauren Purple, Black, and Blue Label, Lauren, RLX, Chaps, and others. The strength of it's branding has allowed the company to enter into licensor relationships, which allows producers of perfumes, colognes, sunglasses, jewelry, and home products to slap the Polo name on their merchandise in order to charge higher prices and increase sales volumes. Polo Ralph Lauren has three main revenue channels. The Wholesale channel (57% of 2008 sales) consists of sales to third party retailers, mainly higher end department stores such as Macy's (M) and Dillard's (DDS). Retail (39%) consists of sales through Polo's company-owned specialty stores, consisting of about 80 Ralph Lauren shops, over 160 Polo factory stores, 70 Club Monaco stores, a handful of Rugby shops, and over 100 international locations. Licensing revenues fill out the sales portfolio.

Polo Ralph Lauren is one of the few apparel brands that has stood the test of time. Founder and still CEO Ralph Lauren founded the company in the late 1960's, took it public in the late 1990's, and has delivered excellent 15% annual gains in operating earnings since then. Financial health and metrics have been strong. The company holds over $880 million in cash and short-term investments, versus total debt obligations of about $420 million. MFI return on capital has been steady and relatively strong at about 42% average since 2004 (nominal ROIC is equally good at about 15%). Free cash flow margin has steadily improved into the low teen's. Polo is financially strong and efficiently run, covering the first investment pillar: financial viability. [more]

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This morning, as always, I opened up the official Magic Formula Investing (MFI) site and was greeted by a very unfamiliar design! The official site had been basically the same since it was launched in 2006, but this re-design changes things dramatically. Looks and layout aside (the site looks much nicer now), below are each of the major changes, as well as some commentary on each: [more]

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Deckers Outdoor (DECK) is a niche, luxury footwear design and marketing firm. Deckers has 4 product brands. The most important is UGG Australia, the well known (and expensive) luxury sheepskin footwear. UGG provided 70% of Decker's total sales for the just completed 2008 fiscal year. The second brand is Teva, focusing on sport sandals. Teva was fully acquired by Deckers about 6 years ago and provided about 12% of 2008 sales. The company also has two additional lines which are less important to current results but are expected to contribute to growth. The Simple brand (2%) is a line of "sustainable footwear", designed using environmentally friendly materials and processes, more popularly known as Green Toe. TSUBO (0.5%) was acquired last year and is a high-end casual footwear line, including dress shoes, sandals, and women's heels. The remainder of sales comes from brand licensing for additional merchandise like handbags, apparel, and so forth.

So, as is the norm, let's look at the positives behind an investment in DECK. There are some good reasons to believe this stock can outperform. First, growth potential. Deckers has grown revenues at an annualized 27% since 2003, and this pace has been escalating, with the past two years revenue growth coming in at about 45%! That's some serious growth. UGG has benefited from substantial cache, mainly celebrity endorsement and media attention. Decker's management plans to grow by introducing new product lines under the existing brands, expanding licensing, acquiring new brands, and pushing it's footwear internationally, where currently the company earns 16% of sales. Assuming the brand portfolio, particularly UGG, can remain strong, there are plenty of growth legs left here. [more]

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When Joel Greenblatt described the Magic Formula Investing (MFI) strategy in his book The Little Book that Beats the Market, one of the most useful decisions he made was to use a company's enterprise value instead of market capitalization when calculating the earnings yield used to find cheap stocks. While most investors rely on metrics such as price-to-earnings (P/E, the inverse of earnings yield) and price-to-book (P/B), they would be better served concentrating on the enterprise value to earnings (EV/E) or enterprise value to book (EV/E). But why? What value does using enterprise value give us over using market capitalization to calculate these valuation metrics? And how do we get enterprise value as used by MFI?

Let's start by examining the "how" first, as it will help to explain the "why". The MFI formula for calculating enterprise value is: [more]